Economics1

Q1. How does the government use the fiscal policy and monetary policy to stabilize the economy? ◆ According to the basic Keynesian model inadequate spending is an important cause of recessions. To fight recessions- at least, those caused by insufficient demand rather than slow growth of potential output- policymakers must find ways to stimulate planned spending. Policies that are used to affect planned aggregate expenditure, with the objective of eliminating output gaps, are called stabilization policies. Policy actions intended to increase planned spending and output are called expansionary policies: expansionary policy actions are normally taken when the economy is in recession. Contractionary policies are policies actions intended to reduce planned spending and output. The two major tools of stabilization policy are monetary policy and fiscal policy. -P651 For example, an increase in government purchases raises autonomous expenditure directly, so it can be used to reduce or eliminate a recessionary gap, Similarly, a cut in taxes or an increase in transfer payments increases the public's disposable income, raising consumption spending at each level of output by an amount equal to the marginal propensity to consume times the cut in taxes or increase in transfers. Higher consumer spending, in turn, raises short-run equilibrium output. -Fiscal policy

Y=PAE
Y=PAE
E
E
950
950
960
960|| 4,750
4,750
4,800
4,800
Output Y
Output Y|(1) The economy is initially at point F, with a recessionary gap of 50: (2) a 10-unit increase in government purchases raises autonomous expenditure by 10 units, shifting the expenditure line up; (3) the new equilibrium is at point E, where output equals potential output. the output gap has been eliminated.

3. Fiscal policy as a stabilization tool: Three qualifications Three qualifications must be made to the use of fiscal policy as a stabilization tool. First, fiscal policy may affect potential output as well as aggregate spending. Second, large and persistent government budget deficits reduce national saving and growth; the need to keep deficits under control may limit the use of expansionary fiscal policies. Finally, because changes in fiscal policy must go through a lengthy legislative process, fiscal policy is not always flexible enough to be useful for short-run stabilization. However, automatic stabilizers- provisions in the law that imply automatic increases in government spending or reductions in taxes when output declines -can overcome the problem of legislative delays to some extent and contribute to economic stability.

-Monetary policy P 688
-Federal Reserve SystemThe central bank of the United States is called the Federal Reserve System, or the Fed for short. The Fed's two main responsibilities are making monetary policy, which means determining how much money will circulate in the economy, and overseeing and regulating financial markets, especially banks. -How Fed's policy change is likely to affect the economy?

In the short run, the Fed can control the real interest rate as well as the nominal interest rate. Since the real interest rate equals the nominal interest rate minus the inflation...

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